Question

Please answer all questions

Select the best answer for each of the following unrelated items.

1. Why have several research studies failed to find strong evidence of the usefulness of the information content of reserve recognition accounting (RRA)?
   1. The relevance of RRA information is low.
   2. The reliability of RRA information is low.
   3. RRA is supplementary information.
   4. RRA uses a 10% discount factor for all oil and gas firms.

2. Which of the following statements best describes the characteristics of the measurement and the information approaches to financial reporting?
   1. The measurement approach uses RRA to recognize assets and liabilities in the statement of financial position.
   2. The information approach has always had a measurement component.
   3. The information approach uses value in use to recognize the year-end values of assets in statements of financial position.
   4. IFRS does not permit assets to be re-valued when a firm uses the measurement approach.

3. Which of the following situations best characterizes the owner-manager agency problem in a firm?
   1. The owner cannot observe the manager’s effort
   2. The availability of managerial talent is scarce in the economy
   3. Managers do not have control over owners’ sales of firm shares to other parties
   4. Managers are often compensated by a combination of salary, bonus, and stock options

4. When regulation does not indicate the nature of disclosure, which of the following statements is correct?

1. Accountants need to behave ethically and encourage firms to produce high-quality information.
2. Accountants need not take an active role in encouraging full disclosure because regulation does not prescribe how to report.
3. Full disclosure will lead to lowering of share prices.
4. Voluntary disclosures will eliminate efficient market anomalies.

6. Why is it important for firms to disclose low-persistence accounting items?
   1. Because investors are interested in the extent to which current reported earnings will persist into the future.
   2. Because managerial bonuses are typically based on low-persistence components of net income.
   3. Because low-persistence items reverse.
   4. Because low-persistence items are valued by investors.

7. Which of the following actions of the manager of a borrowing firm might cause a moral hazard problem between the manager and the lender?
   1. The manager pays excessive dividends to the shareholders.
   2. The manager undertakes low-risk projects.
   3. The manager pays off the loan prior to the maturity date.
   4. The manager decides to smooth its net income over time.

8. One of the problems that might cause market failure in the production of financial accounting information is said to be lack of unanimity. Which of the following statements best characterizes the notion of lack of unanimity that might lead to market failures?
   1. Investors disagree amongst themselves about how much information should be produced.
   2. Managers disagree amongst themselves about how much information should be produced.
   3. Managers and auditors disagree about how much information should be produced.
   4. Investors and managers disagree about how much information should be produced.

1. Managerial compensation is often based on the net income of a firm (or bonus) as well as share prices of the firm (or employee stock options, ESOs). Which of the following statements about the efficiency of the resulting managerial compensation plan is correct?
   1. The higher the correlation between net income and share prices, the more efficient the management compensation contract.
   2. When management compensation consists of only a bonus or only ESOs, this leads to an efficient management compensation contract.
   3. The lower the correlation between net income and share prices, the more efficient the management compensation contract.
   4. Using a fixed salary and a bonus to compensate managers results in a more efficient management compensation contract than having a bonus and employee stock options in the contract.

10. Which of the following statements provides the best description of agency cost in a situation where an owner of a firm has entered into an employment contract with the manager of the firm?
    1. The agency cost of a contract is the manager’s total annual compensation as a percentage of the market value of assets plus the book value of debt.
    2. Agency cost is the amount by which the owner’s utility from the contract is less than the owner’s utility for the first-best contract.
    3. The agency cost of a contract is the proportion of the manager’s total compensation as a percentage of the firm’s revenues.
    4. The agency cost of a contract equals the manager’s reservation utility.

Answer 1

Soutions:

b.)

For financial information to be useful, the information should be both relevant and reliable. RRA information lacks reliability because of frequent estimate changes and error corrections. RRA information is relevant because it is based on future cash flows and hence option 1) is incorrect. Option 3) is incorrect. RRA is indeed supplementary information, but its usefulness is low because its reliability is low, not because it is supplementary information. A common 10% discount factor could reduce RRA’s reliability and hence its usefulness. But option 2) is a better answer than option 4) because it addresses RRA’s reliability in its entirety.

c.)

Option 2) is correct because the information approach has always had a measurement component, such as ceiling tests and lower of cost or market. Option 1) is incorrect because RRA is supplemental information only and not used to recognize assets and liabilities in financial statements. Option 3) is incorrect because the information approach uses amortized cost to recognize year-end assets and not value in use. Option 4) is incorrect because IFRS permits the revaluation option unconditionally.

d.)

The genesis of the agency problem lies in the fact that managers’ efforts are not observable by owners and this gives rise to compensation components like bonuses and stock options. Thus option 1) is a better answer than option 4), which follows from option 1). Option 3) and option 2) do not cause agency problems and are incorrect.

e.)

Even if the regulation does not indicate the nature of disclosure that firms are required to make, the accountant needs to act ethically and encourage firms to adopt a policy of full disclosure. This will not only benefit the firm by lowering its cost of capital but also benefit society by ensuring that resource allocation in the economy is carried out in an optimal manner. Thus, options 2) and 3) are incorrect. There is no evidence that voluntary disclosures will eliminate anomalies. Thus, option 4) is incorrect.

f.)

The reason why firms disclose low-persistence items is that shareholders are interested in the components of earnings that are likely to persist into the future. These persistent items of earnings are valued by shareholders rather than transitory items. Option 2) is incorrect because managerial compensation is more related to high-persistence rather than low-persistence items. Option 3) is incorrect because while some low-persistence items do reverse, not all do, thus option 1) is a better answer than option 3). Option 4) is incorrect because investors do not value low-persistence items.

g.)

None of the other options create a moral hazard problem between the lender and the borrower. Payment of excessive dividends leaves less funds for the lenders to be repaid and might cause a moral hazard problem. Thus, options 2), 3), and 4) are incorrect.
h.)
The problem of unanimity arises when shareholders (investors) and managers do not agree about the amount of information the firm should produce. Shareholders demand more information than the manager wants to release. This gives rise to the problem of lack of unanimity. The problem is not one that might arise if different investors or different managers disagree amongst themselves about the amount of information, or if managers and auditors disagree either. Thus options 1), 2), and 3) are incorrect.
i.)
Using a second performance measure makes for a more efficient compensation contract than a contract based on one measure only, as long as the second measure provides some extra information about managerial effort. The most efficient contract is achieved when net income and share prices are not correlated. Thus, option 1) is incorrect. Option 2) is incorrect because the second performance measure has the potential to add more information about managers’ effort. Using a fixed salary does not provide any extra information about managerial effort and thus option 4) is incorrect.
j.)
The owner achieves maximum utility when the first-best contract is available; the owner achieves the maximum attainable utility while providing the manager his or her reservation utility. This can happen only if the manager’s effort is observable or can be directly inferred. Agency cost is the reduction in the principal’s utility when the first-best contract cannot be attained. Thus, options 1), 3), and 4) are incorrect.